In our wealth-tech series, we analyse different wealth-tech products and their legal status. You can read all the posts here.

There's always an opportunity with crisis, they say. The 2008 financial crisis wasn't any different. It didn't spare the behemoths of the investment world, let alone small investors. The market was in turmoil. Meanwhile, Jon Stein was banking on this?opportunity?to make investments more convenient. His solution – the first robo adviser,?Betterment.??

Since then, robo advisory has soared in popularity. And the demand for low-cost investment advice continues to drive its growth. The global robo advisory market is?projected?to be $54.15 billion by 2028 with a CAGR of 31.84% from 2021-2028.??

So, how does robo advisory work??

Robots can stir up images of superheroes like Arnold Schwarzenegger's? Terminator?in the sequel films. Well,?robo advisers?are heroes for investors (except there is no armoured suit or humanoid figure). They're known by different names – 'robo investing', 'digital advisers' or 'smart portfolios'. They provide financial services using AI/ML algorithms. These algorithms generate viable portfolio options with little or no human interference. Robo advisory has application in trading, lumpsum investment, SIPs, portfolio rebalancing and?tax-loss harvesting, among others. In short, robo advisers enable automation of investments. Traditional financial advisers, however, continue to remain suited for complex services (like estate planning).??

Let's say you want to build a nest egg for your retirement or your child's graduation. A robo adviser will ask you certain questions. Like your current age, income, retirement age, fund amount, risk tolerance, current assets, etc. Based on this information, the robo adviser will automatically allocate assets across equity, debt, commodities, etc. And curate the most efficient investment portfolio suited to your investment objectives.?????

Robo advisory has two variations – (a) pure robo advisers; and (b) hybrid robo advisers. As the term suggests,?pure robo advisers?are completely free from human intervention in the advisory and execution process. Hybrid robo advisory, however, combines robotic algorithms with human touch-points. So, in the latter category, while portfolios may be generated through automation, there is scope for human?intervention?(to make judgement calls), interaction, advice and customization. Currently, the market sentiment tilts more towards the hybrid model. Because human financial planners may?mitigate?risks that pure robo advisers pose like incorrect advice resulting from algorithmic flaws.??

Now let's explore how SEBI regulates robo advisers.??

Current law: Investment advisory services are governed by?SEBI (Investment Advisers) Regulations, 2013?(IA Regulations). In a?2016 Consultation Paper, SEBI clarified that IA Regulations also apply to investment advisers (IAs) using automated tools. Further, in a?2020 Board Memorandum, SEBI stated that entities that provide investment advisory using automated tools are registered as IAs. So, all compliance requirements applicable to traditional IAs apply to robo advisers too. These include executing a?physical agreement, and maintaining detailed records of clients' risk-profiling, suitability assessment of advice and interactions with clients. Further, mutual funds providing robo advisory have to?submit?quarterly reports to SEBI. The?reports?must detail the AI/ML applications used to provide investment advice, cyber-security controls, and other safeguards for AI/ML systems. Similar?obligations?also apply to other intermediaries (like stock brokers and depository participants) that use automated tools for investment advisory.??

Proposed regulation: In the 2016 Consultation Paper, SEBI also proposed certain additional compliances (over and above IA Regulations) for robo advisory. These were: (a) using automated tools in the client's best interests; (b) ensuring automated tools are 'fit' for the purpose and used for target clients (for whom it's designed) only; (c) disclosure to clients on the working and limitations of automated tools; and (d) audit and inspection of automated tools. But these proposals haven't been implemented yet.??

The new generation of investors – Millennials and Gen-Z – are a growing force in investing. They're looking for innovative yet affordable investment solutions to manage their wealth – something that robo advisers offer. With many traditional IAs?exiting?the market (for various reasons), robo advisers are in luck. The demand for IAs is huge. By leveraging technology, robo advisers can uplift the supply side of the investment advisory market. Further, with SEBI?joining?RBI's Account Aggregator framework, robo advisers (and investors) have much to gain. Through Account Aggregators, robo advisers can seamlessly collect information about an investor's financial assets and liabilities from multiple sources – banks, NBFCs, mutual funds, insurance companies, etc. They can then?process?this data to curate tailored portfolios.??

But presently, there are no formal guidelines that specifically cater to robo advisory. Ensuring compliance with requirements like executing physical agreements and maintaining voluminous records is cumbersome for robo advisers. This also means greater user friction and increased manpower for robo advisers, which?undermines?their ability to achieve scale and lower costs. Allowing e-signing of IA agreements and rationalising record keeping requirements can enable growth of robo advisory in India.???

IA Regulations do?mention?that automated tools for risk profiling must be 'fit' for the purpose. But they don't specify standards for managing risks embedded in algorithmic tools. In light of prevailing regulatory uncertainty, robo advisers must have strong internal policies built on best practices. Here, lessons can be taken from?guidelines?framed by foreign regulators like the US Securities and Exchange Commission (SEC) for robo advisory. IOSCO's?Report?on Automated Advice Tools also gives some direction on robo advisory. First, investors must know what factors are considered by the robo adviser while providing investment advice. For instance, if an algorithm doesn't consider the investor's tax liability, the scope of advisory should clearly exclude tax. Second, responsibility for advice given by robo advisers will rest with the IA using the automated tool. So, it's critical that persons who develop and/or use algorithms for robo investing are competent and adequately trained.??

Further, IAs must not make false claims when marketing their robo advisory services. Else they could be?penalized? by SEBI. For instance, a New York-based robo adviser?Wahed Invest, LLC?was?charged?by SEC for making misleading statements. Wahed allegedly misled robo advisory clients to believe that their assets will be invested in investment companies but they were actually invested in equities. Wahed also allegedly failed to regularly rebalance its robo advisory clients' accounts as promised. In another instance, subsidiaries of?The Charles Schwab Corporation?were?penalized?by SEC for charging hidden fees for their robo-adviser products. Both Wahed and Schwab agreed to pay the penalty, and gave undertakings to SEC.?????

Lastly, robo advisory tools can be offered by asset management companies, banks, NBFCs, or even fintechs. Standard guidelines for different classes of entities offering robo advisory will maintain uniformity in regulation. An RBI committee had earlier?recommended?uniform guidelines for robo advisers framed through cooperation between all financial regulators (including RBI, IRDAI & PFRDA). Well, we hope robo advisers get a clear and enabling regulatory framework, hopefully before the Terminator 7 adventure!?

(This post has been authored by the fintech team at Ikigai Law.)

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